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What the new bill takes a hammer to is which banks, if any, are thought of as systematically important financial institutions—Dodd-Frank lingo for too big to fail. The new bill, if signed by the president, is a boon for smaller banks. Regulations were time-consuming and costly, banks argued, slimming profits needlessly. And the downside of failing a stress test was bad news for bank shareholders. To be clear, the bill lightens the load on far more than small, local credit unions and community banks. Still, the new bill may be largely symbolic.

Whether the latest version of Dodd-Frank maintains its muscle, though, is ultimately up to the Federal Reserve, which gets large discretion in determining the size and scope of regulation for medium and small banks. Skip to navigation Skip to content. More symbolic than anything else Still, the new bill may be largely symbolic. The test is whether it protects consumers and investors. And the test is also whether it can do so while supporting, not harming, the economy. In the lead up to , our system failed that test. That is why comprehensive reform was essential. The Act provides for supervision of major firms based on what they do, rather than their corporate form.

The largest financial firms will be required to build up their capital and liquidity buffers, constrain their relative size, and place restrictions on the riskiest financial activities. The Act comprehensively regulates derivatives markets with new rules for exchange trading, central clearing, transparency, anti-abuse provisions, and capital and margin requirements.

The Act provides for data collection and transparency so that in no corner of the financial markets can risk build unnoticed. The Act creates an essential mechanism for the government to orderly liquidate failing financial firms without putting taxpayers at risk. The Act creates a new Consumer Financial Protection Bureau and provides for consumer and investor protections.


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In sum, the Act provides a strong foundation on which the U. Before Dodd-Frank, if an entity were a bank, then it had tougher regulation, more stringent capital requirements, and more robust supervision. But if an entity were an investment bank engaged in the same activities, then it was able to abide by different rules. For example, when U.

The SEC was not established as a prudential regulator, did not have clear regulatory oversight for investment bank holding companies, and had little experience and few trained examiners. Moreover, the leverage requirement that served as a backstop for capital requirements on banks was not applied to these investment banks.

In effect, the system allowed large financial institutions to choose the regulator that would offer the least restrictive supervision. Eberly and James H. The Federal Reserve did not have any authority to set and enforce capital requirements on the major institutions that operated businesses outside of bank holding companies. That meant it had no supervision over investment banks, diversified financial institutions like AIG or the nonbank financial companies competing with banks in the mortgage, consumer credit and business lending markets.

And regulators permitted banks and thrifts themselves to engage in risky mortgage lending, stepping in with guidance only when it was too late. Today, Dodd-Frank has provided authority for clear, strong and consolidated supervision and regulation by the Federal Reserve of any financial firm—regardless of legal form—whose failure could pose a threat to financial stability.


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We will have a single point of accountability for tougher and more consistent supervision of the largest and most interconnected financial firms. All bank holding companies will be supervised by the Fed, and the largest ones will be subject to heightened standards. Non-bank financial institutions designated by the Financial Stability Oversight Council will also be Fed-supervised. The voluntary investment bank holding company regime has ended. Dodd-Frank provides for more stringent prudential standards for these major bank and nonbank firms. The Fed is charged with putting in place stronger requirements for capital and liquidity.

Annual stress tests will be conducted on these firms. There are enhanced rules on affiliate transactions, lending limits, and counterparty credit exposures.

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The Fed is required to use macro-prudential supervision, which takes into account not only the risks within the institution, but the risks that the institution poses to the financial system as a whole. Before Dodd-Frank, no regulator or supervisor had the legal authority or responsibility to look across the full sweep of the financial system and take action when there was a threat. Our financial markets have suffered for the lack of an effective system for monitoring and responding to systemic risks or threats to financial stability as they arise.

The FSOC will have access to information across the financial services marketplace. A new Office of Financial Research is empowered to collect data from any financial firm, and to develop and enforce standardization for data collection. Enormous risks built up in these markets — without effective constraints or any robust monitoring by regulators.

Kent Smetters, PhD

Credit derivatives, which were supposed to diffuse risk, instead concentrated it. Synthetic securitization with embedded derivatives magnified failures in the real securitization market. Major financial firms used derivatives to increase their credit exposure to each other, rather than decrease it. The opacity of this market meant that the government and market participants did not have enough information about the location of risk exposures in the system or the extent of the mutual interconnections among large firms.

So, when the crisis began, regulators, financial firms, and investors had an insufficient understanding of the degree to which trouble at one firm spelled trouble for another. This lack of information magnified contagion as the crisis intensified, causing a damaging wave of margin increases, deleveraging, and credit market breakdowns. Lack of transparency, insufficient supervision, and inadequate capital left our financial system vulnerable to concentrations of risk, and to abuse.

Today, regulators are putting in place the tools to comprehensively regulate the OTC derivatives market for the first time. The Act provides for regulation and transparency for transactions in this market.

It provides for strong prudential, capital, and business conduct regulation of all dealers and other major participants in the derivatives markets. And it provides for regulatory and enforcement tools to go after manipulation, fraud, and other abuses in these markets. The Act requires all standardized derivatives to be centrally cleared, which will substantially reduce the build-up of bilateral counterparty credit risk between major financial firms. Central clearing parties would be subject to strong prudential supervision. Such derivatives would be traded on exchanges or alternative swap execution facilities, which would improve pre- and post-trade price transparency.

Exchange trading will help to improve price competition as well as to improve safety and soundness in the derivatives system, as market participants and regulators will have full access to current prices in the event of system disruptions. Even non-centrally cleared OTC derivatives would be reported to a trade repository, making the market far more transparent.

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The Act provides for prudential regulation of all OTC dealers and all other major players in the OTC markets, so that adequate capital, business conduct rules, and prudential supervision will apply to all market participants. The Act provides for robust capital and initial margin requirements for derivative transactions that are not centrally cleared, providing a strong incentive to use central clearing and a bigger buffer should problems arise in the OTC markets.

In the lead up to the financial crisis, major financial firms became increasingly funded not by traditional bank deposits, or even longer-term funding in the commercial markets, but rather by overnight funding in the repo markets. And these markets became increasingly concentrated in only two major clearing banks.

More symbolic than anything else

As the market became more concentrated, it also became riskier because counterparties came to accept not only Treasury securities as collateral, but also highly rated asset-backed securities. And these securities, in turn, became riskier, as credit rating agencies became increasingly willing to label as safe assets that were lower quality—including pools of securities backed only by poorly underwritten subprime and Alt-A mortgages.

When the financial crisis hit, the repo markets froze, causing a massive contraction in available credit. The Dodd-Frank Act fundamentally reforms the wholesale funding markets by providing strong authority for the Federal Reserve to regulate financial market utilities and critical payment, clearing, and settlement activities; to set new rules for capital, collateral and margin requirements; and to establish uniform prudential standards across the market.

These reforms are coupled with basic changes to liquidity requirements for major financial firms under the Basel III rules, liquidity concentration limits under the Act, and reforms to the deposit insurance system that will encompass all depository liabilities. These reforms will have the effect of taxing short-term liabilities and forcing firms to internalize more of the costs of this funding system. At the same time, SEC changes to regulations of money market mutual funds under Rule 2a-7 will mean that such funds have stronger liquidity positions.

The Act also fundamentally transforms regulation of the last major element of the shadow banking system—securitization. The Act requires deep transparency into the structure of securitizations, including information about the assets and originators. Securitization sponsors must generally retain risk in the securitizations they sponsor, so that incentives are better aligned among participants in the system. Capital rules will better account for actual risk.

Parallel changes in accounting rules will now bring the most common forms of securitizations onto the balance sheet. Credit rating agencies will be subject to comprehensive oversight by the SEC, including policing of ratings shopping and conflicts of interest; ratings themselves will be more transparent—including key information on rating methodology, compliance with methodology, underlying qualitative and quantitative data, due diligence, and other protections.

Before Dodd-Frank, consumer protection regulation was fragmented over seven federal regulators, most of which chose to focus their energies in areas other than protecting consumers. Regulators lacked mission focus, market-wide coverage, and consolidated authority. Nonbanks could avoid federal supervision. Banks could choose the least restrictive consumer approach among several different banking agencies.

Bank Regulation, Too Big To Fail, and Liquidity, S6, April 2016

Federal regulators preempted state consumer protections laws without adequately replacing these important safeguards. Fragmentation of rule writing, supervision and enforcement led to finger-pointing in place of effective action. Today, the Consumer Financial Protection Bureau has market-wide coverage. The Bureau will focus on more effective regulation and supervision. The CFPB will set high and uniform standards across the market. It will focus on improving financial literacy for all Americans. And it will help to end profits based on misleading sales pitches and hidden traps; rather, banks and nonbanks can compete vigorously for consumers on the basis of price and quality.

Before Dodd-Frank, the government did not have the authority to unwind large, highly leveraged, and substantially interconnected financial firms that failed — such as Bear Stearns, Lehman Brothers, and AIG — without disrupting the broader financial system.

Such a presumption reduced market discipline and encouraged excessive risk-taking by firms. It provided an artificial incentive for large firms to grow even larger. It created an unlevel playing field with smaller firms. And when the financial crisis hit, it left the government with the untenable choice between taxpayer-funded bailouts and financial collapse.

Too Big Not To Fail | National Affairs

And should such a firm fail, there will be a bigger capital buffer to absorb losses. These measures will help to reduce risks in and among the largest financial institutions. Thus, bankruptcy proceedings will remain the dominant option for handling the failure of a non-bank financial institution. The crisis, however, showed that the U. That is why the Dodd-Frank Act permits the government, in limited circumstances, to resolve the largest and most interconnected financial companies outside of the traditional bankruptcy regime and consistent with the approach long taken for bank failures.

This is the final step in addressing the problem of moral hazard. To make sure that we have the capacity — as we do now for banks and thrifts — to break apart or unwind major non-bank financial firms in an orderly fashion that limits collateral damage to the system.